Adjusting Entries

• There is more to the measurement of business income than

merely recording simple revenue and expense transactions that
affect only a single accounting period.
• Certain transactions affect the revenue or expenses of two or
more accounting periods. The purpose of adjusting entries is to
assign to each accounting period appropriate amounts of
revenue and expense.
• For example, Overnight Auto Service purchased shop supplies
that will be used for several months.
• Thus, an adjusting entry is required to record the expense
associated with the shop supplies that Overnight uses each
month.
 THE NEED FOR ADJUSTING ENTRIES
• For purposes of measuring income and preparing financial
statements, the life of a business is divided into a series of
accounting periods. This practice enables decision makers
to compare the financial statements of successive periods
and to identify significant trends.
• But measuring net income for a relatively short
accounting period—such as a month or even a year—
poses a problem because, as mentioned above, some
business activities affect the revenue and expenses of
multiple accounting periods. Therefore, adjusting entries
are needed at the end of each accounting period to make
certain that appropriate amounts of revenue and expense
are reported in the company’s income statement.
• For example, magazine publishers often sell two- or three-
year subscriptions to their publications.
• At the end of each accounting period, these publishers make
adjusting entries recognizing the portion of their advance
receipts that have been earned during the current period.
• Most companies also purchase insurance policies that
benefit more than one period. Therefore, an adjusting entry
is needed to make certain that an appropriate portion of
each policy’s total cost is reported in the income statement
as insurance expense for the period.
• In short, adjusting entries are needed whenever
transactions affect the revenue or expenses of more than
one accounting period. These entries assign revenues to the
period in which they are earned, and expenses to the
periods in which related goods or services are used.
 TYPES OF ADJUSTING ENTRIES
• 1. Converting assets to expenses. A cash expenditure (or
cost) that will benefit more than one accounting period
usually is recorded by debiting an asset account (for
example, Supplies, Unexpired Insurance, and so on) and by
crediting Cash.
• The asset account created actually represents the deferral
(or the postponement) of an expense. In each future period
that benefits from the use of this asset, an adjusting entry is
made to allocate a portion of the asset’s cost from the
balance sheet to the income statement as an expense. This
adjusting entry is recorded by debiting the appropriate
expense account (for example, Supplies Expense or
Insurance Expense) and crediting the related asset account
(for example, Supplies or Unexpired Insurance).
• 2. Converting liabilities to revenue. A business may
collect cash in advance for services to be rendered in
future accounting periods. Transactions of this nature
are usually recorded by debiting Cash and by crediting a
liability account (typically called Unearned Revenue).
• Here, the liability account created represents the
deferral (or the postponement) of a revenue. In the
period that services are actually rendered (or that goods
are sold), an adjusting entry is made to allocate a
portion of the liability from the balance sheet to the
income statement to recognize the revenue earned
during the period. The adjusting entry is recorded by
debiting the liability (Unearned Revenue) and by
crediting Revenue Earned (or a similar account) for the
value of the services.
• 3. Accruing unpaid expenses. An expense may
be incurred in the current accounting period
even though no cash payment will occur until
a future period. These accrued expenses are
recorded by an adjusting entry made at the
end of each accounting period. The adjusting
entry is recorded by debiting the appropriate
expense account (for example, Interest
Expense or Salary Expense) and by crediting
the related liability (for example, Interest
Payable or Salaries Payable).
• 4. Accruing uncollected revenue. Revenue may
be earned (or accrued ) during the current
period, even though the collection of cash will
not occur until a future period.
• Unrecorded earned revenue, for which no cash
has been received, requires an adjusting entry
at the end of the accounting period. The
adjusting entry is recorded by debiting the
appropriate asset (for example, Accounts
Receivable or Interest Receivable) and by
crediting the appropriate revenue account (for
example, Service Revenue Earned or Interest
Earned).
 THE CONCEPT OF DEPRECIATION
• Depreciable assets are physical objects that retain their
size and shape but that eventually wear out or become
outdated. They are not physically consumed, as are assets
such as supplies, but nonetheless their economic
usefulness diminishes over time. Examples of depreciable
assets include buildings and all types of equipment,
fixtures, furnishings—and even railroad tracks. Land,
however, is not viewed as a depreciable asset, as it has an
unlimited useful life.
• Each period, a portion of a depreciable asset’s usefulness
expires. Therefore, a corresponding portion of its cost is
recognized as depreciation expense.
• What Is Depreciation? In accounting, the term
depreciation means the systematic allocation of
the cost of a depreciable asset to expense over
the asset’s useful life.
• Depreciation is not an attempt to record changes
in the asset’s market value. In the short run, the
market value of some depreciable assets may
even increase, but the process of depreciation
continues anyway. The basis for depreciation lies
in the matching principle. Our goal is to offset a
reasonable portion of the asset’s cost against
revenue in each period of the asset’s useful life.
• Depreciation expense occurs continuously over the
life of the asset, but there are no daily
“depreciation transactions.” In effect, depreciation
expense is paid in advance when the asset is
originally purchased. Therefore, adjusting entries
are needed at the end of each accounting period to
transfer an appropriate amount of the asset’s cost
to depreciation expense.
• Depreciation Is Only an Estimate The appropriate
amount of depreciation expense is only an
estimate. After all, we cannot look at a building or
a piece of equipment and determine precisely how
much of its economic usefulness has expired
during the current period.
• The most widely used means of estimating periodic
depreciation expense is the straight-line method of
depreciation. Under the straight-line approach, an
equal portion of the asset’s cost is allocated to
depreciation expense in every period of the asset’s
estimated useful life.
• The formula for computing depreciation expense by
the straight-line method is:
• Depreciation expense ( per period )=
• Cost of the asset/Estimated useful life
• The use of an estimated useful life is the major reason
that depreciation expense is only an estimate. In most
cases, management does not know in advance exactly
how long the asset will remain in use.
• Depreciation of Overnight’s Building Overnight
purchased its building for $36,000 on January 22.
Because the building was old, its estimated remaining
useful life is only 20 years. Therefore, the building’s
monthly depreciation expense is $150 ($36,000
cost/240 months). The adjusting entry to record
depreciation expense on Overnight’s building for the
month of December is:
• Dec. 31 Depreciation Expense:
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
• Accumulated Depreciation:
Building . . . . . . . . . . . . . . . . . . . . . . . 150
• December building depreciation adjusting entry
($36,000 240 mo.).
• Accumulated Depreciation: Building account will be reported in
the December 31 balance sheet as a deduction from the
Building Account, as shown below.

• Accountants often use the term book value (or carrying value )
to describe the net valuation of an asset in a company’s
accounting records. For depreciable assets, such as buildings
and equipment, book value is equal to the cost of the asset, less
the related amount of accumulated depreciation. The end result
of crediting the Accumulated Depreciation: Building account is
much the same as if the credit had been made directly to the
Building account; that is, the book value reported in the balance
sheet for the building is reduced from $36,000 to $34,350.
• Book value is of significance primarily for
accounting purposes. It represents costs that will
be offset against the revenue of future periods.
• It also gives users of financial statements an
indication of the age of a company’s depreciable
assets (older assets tend to have larger amounts
of accumulated depreciation associated with
them than newer assets). It is important to
realize that the computation of book value is
based upon an asset’s historical cost. Thus, book
value is not intended to represent an asset’s
current market value.